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FRM Part II · FRM Exam Part II · Capital Regulation Before the Global Financial Crisis

A bank held securitization tranches rated AAA that were warehoused in its trading book and held for resale. Before the crisis, the market risk capital rules applied a 10-day 99% VaR multiplied by a factor to such positions, and the models used a recent calm-period history. Which combination best describes why capital proved inadequate when the market deteriorated?

The best explanation is that VaR based on a short, benign data window and a 10-day horizon ignored default and migration risk and the illiquidity of securitization tranches. The measure therefore understated potential losses, so trading book capital was far too low when markets deteriorated.

  1. AVaR measured over a short, benign window ignored default and migration risk and illiquidity of the tranches, so capital understated lossesCorrect
  2. BVaR was calculated at 95% confidence, which understated tail losses
  3. CThe multiplier was reduced after each backtesting exception
  4. DTrading book positions were risk-weighted at 100% under the standardized credit approach

Explanation

Pre-crisis trading book VaR relied on short, calm data windows and a 10-day horizon, which was far shorter than the true liquidation time of illiquid structured products. It also did not capture default and rating migration risk. Together these caused capital for securitization exposures to be far too low. The confidence level was 99%, and exceptions raise rather than lower the multiplier.

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